Weakening US fundamentals and improved investor sentiment in Europe, combined with President Trump’s trade war, have led to questions being asked about the dollar’s durability.
Donald Trump’s election in November 2024 initially drove the US dollar higher as the currency was supported by the prospect of higher tariffs and stimulus measures for the US economy. However, the new president’s intention to reform the global trade and financial system is likely to cause the greenback to fall back over the medium to long term. The currency’s recent drop may be the onset of a deeper underlying trend, and Mr Trump’s second term could see the dollar lose the dominant status it has enjoyed over the past decade.
Is this the end of the so-called ‘Golden Age’ for the US dollar? This is the question everyone is asking on account of the country’s soaring debt, although the dollar has beaten the odds over the past 15 years.
Bolstered by its status as a currency reserve, a safe haven amid geopolitical tensions — particuarly the Russia-Ukraine war — American exceptionalism, and the positive momentum on interest rates, the dollar has been rising steadily and is now largely overvalued. These factors combined have prompted many international investors to keep a large share of their investments exposed to the dollar. With time, they have forgotten the risks this overexposure can imply.
Since 2008 and the subprime crisis, the Dollar Index (average price of the dollar relative to a basket of global currencies) has risen more than 40 per cent, with just a few episodes of weakness (only four bearish years in the past 15).
However, weakening fundamentals have sent the dollar into a downward correction. Recent economic data for the US, which came in below expectations, and concerns over the country’s technology sector, have raised doubts over the resilience of the US economy.
European renaissance
The announcement of a vast investment plan in Germany and defence spending in Europe — which would imply likely revision of fiscal rules — as well as hopes the war in Ukraine will soon come to an end, has improved investor sentiment in Europe.
Indeed, the dollar has suffered from this change of perception and has already lost 4 per cent against the European currency from its peak at the start of the year, while the global Dollar Index fell by 5 per cent. The impact of these factors is already considerable, with Mr Trump’s trade war and his plans to restructure the global financial system putting the dollar at even greater risk.
This restructuring, theorised by Stephen Miran, Donald Trump’s senior economic adviser, is based on belief that the dollar must depreciate to allow for the reindustrialisation of the US. Tariffs are a central feature of his strategy, prompting other countries to reach an agreement on currencies. This is referred to as the ´Mar-a-Lago’ agreement — similar to past currency agreements named according to where they were signed — such as Bretton Woods (1944), Plaza (1985) and Louvres (1987).
Punitive measures
Mr Miran’s theory is based on several factors. In 2018, the impact of the trade war had been largely mitigated by the diversion of some of China’s imports via transit countries. This prompted Mr Trump to set blanket tariffs, not only as a punitive measure but also to raise the weight of tariffs in the overall federal state income.
Unlike in 2018, tariffs today serve as an economic tool with several objectives beyond mere bargaining leverage. They are being used to restore the country’s trade balance, sanction other countries for economic or national security reasons, and generate tax income to reduce the country’s deficit.
Additionally, the dollar’s over-valuation stems from accumulation of dollar reserves by governments seeking a safe haven. However, this trend has already reversed in recent years and could gather further speed if the global financial system is called into question.
The process of ‘de-dollarisation’ is also well underway, with declining weight of the dollar in global currency reserves having accelerated since sanctions against Russia. This trend is expected to continue on account of the wrestling match initiated by the Trump administration. The first benefit of ‘de-dollarisation’ has been the soaring price of gold, which has become the main reserve asset in the absence of a currency that could offer a true alternative to the dollar. The price of an ounce of gold has climbed more than 60 per cent to reach $2,920. However, a ´Mar-a-Lago’ agreement will be difficult to achieve.
Times have changed since the Plaza agreement. Today, much of the world’s dollar reserves are held by Asian and Middle Eastern countries, no longer by European countries. It is likely the former will be less conciliatory with the US than Europeans were during the cold war. The trade war, and the tension and negotiations that will follow, should fuel higher volatility across currency markets in the months to come.
The zero-rate monetary policies implemented by the world’s main central banks between 2011 and 2022 have anesthetised foreign exchange markets. This lack of volatility combined with a strong dollar had prompted many investors to step back from currency risk and overlook the currency hedging strategies of recent years. This risk can no longer be ignored today.
Benjamin Dubois, head of overlay management, Edmond de Rothschild Asset Management
